Much has been written about risk and how it should be defined with respect to investment. Although the volatility of short-term returns is the widely accepted measure, some have proposed measuring risk in terms of whether you achieve your investment goals. In the case of retirement savings, this is about whether the performance of your portfolio allows you to have the life in your twilight years that you had been working towards.
I certainly like of the idea of defining volatility in terms of whether you reach your investment goal, rather than short-term volatility. The former risk relates to permanent loss of capital – if you fail to achieve your goal then the shortfall is one you can never make up. Short-term volatility on the other hand should simply be viewed as a cost of seeking to achieve your long-term goal rather than a risk to be avoided – unless you have an absurdly unambitious goal your portfolio will always have its ups and downs from year to year.
However, the problem with defining risk in terms of long-term rather than short-term performance is that one may be tempted to think that long-term returns from bonds or equities are reliable.
They’re not. They’re reliably un-reliable.
A US Treasury investor would have lost 48% of his real capital from 1900 to 1920, a period of 20 years. Had he begun investing in 1940 he would have lost 63% over the next 41 years. In Japan, an equity investor starting out in 1989 would have seen a decline in the real value of his portfolio of 70% over the next 22 years.
Not only should clients be aware of the risks of markets not behaving as we generally expect them to over the long term but, more importantly, they should be informed of the very real risk of long-term goal failure that confronts them today – famed investor Jeremy Grantham warned only in April that, “the stock market will break a lot of hearts in the next 20 years”.
With the 30-year inflation-linked gilt yield of -1.8% currently, your total real return to maturity is a loss of 42.1%. Furthermore, there is no risk to this scenario – the real loss is guaranteed. In fact, real losses on straight (nominal) gilts will be even worse than those on ‘linkers’ if inflation over the longer term is higher than the 3.4% currently anticipated, which it might well be.
In 1992, the yield on the 30-year linker reached 4.6% which meant a total real return to maturity of +286%. It is possible that our judgment about future returns from gilts is being clouded by their fantastic returns over the last few decades.
Perhaps counterintuitively, there is less of a risk for equities. Companies may well experience the same headwinds that would crucify real bond returns such as higher inflation. However, they can do things to mitigate their effect: they can adjust selling prices, capital expenditure or expenditure on labour among other things. Bonds, with their fixed coupons, do not have this luxury.
What can be done to address the possibility that future real returns from traditional asset classes may not be as good as they have been in recent decades? In my view, possible solutions fall into two categories: those that require action now and those that require action along the way.
‘Action now’ means accepting that traditional safe assets such as gilts or treasuries are no longer safe and that for safety you need to look elsewhere. Examples might include infrastructure trusts or defensive equities such as Unilever or National Grid. Note that these will exhibit higher short-term volatility than safe-haven bonds but, remember, it is long-term goals that are important. Infrastructure trusts that yield 4% and whose revenues are explicitly linked to inflation – yes, they do exist – have a very good chance of returning more than -1.8% per annum in real terms.
‘Action along the way’ means responding appropriately to drawdowns in portfolio value that may occur on your journey towards your goal. If long-term returns are going to be lower than they have been in recent decades, you’d expect the drawdowns either to be bigger or more frequent, or both. Responding to them in the right way is paramount.
A 1994 paper by aeronautical-engineer-turned-financial-planner Bill Bengen proposed that clients whose portfolios had been impacted by a period of particularly poor equity market performance early in retirement would be best served by a temporary increase in their portfolio’s equity exposure to 100%.
I would not advocate 100% equities for anyone in retirement under any circumstance. However, I absolutely endorse responding to poor market performance in the right way. Seeking out alternatives to expensive safe-haven bonds, as well as being ready to increase risk exposure, perhaps significantly, to take advantage of any weakness in markets will be key.
Peter Elston is chief investment officer at Seneca Investment Managers